Massive positions are just starting to be unwound in the credit default swaps market as tens of billions of dollars worth of these contracts are now getting settled in the aftermath of several high-profile flops.

Banks are hoarding cash in expectation of expected payouts on anywhere from $200bn to $1 tn--no one knows the amount, adding to volatility--for defaulted credit derivatives linked to the collapse of Lehman Brothers, the government's seizure of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE), the government's rescue of American International Group (AIG), and the failure of Washington Mutual (WM).

The swaps on derivatives on these companies are now being settled.

Banks, insurance companies, pension funds, hedge funds, you name it, even sovereign wealth funds have sold CDSs and may have to pay out big-time. The derivatives are roiling money market funds which supply funding to businesses who borrow in commercial paper markets. 

The Reserve Primary Fund had invested in Lehman's debt securities, and when those investment went south, the fund broke the buck, leaving investors unlikely to get back all the cash they put in as the fund failed to keep assets of at least $1 for every dollar invested.  

This unwinding is causing banks to hoard cash and the stock market to boomerang wildly. It's one of the reasons why the Federal Reserve is making historic moves to unclog the credit system with its recent bid to buy unsecured commercial paper from non-banks.

And the tumultuous CDS auctions are behind the push I've been reporting to you since last spring to set up a central clearinghouse to take care of these trades, which occur now in the murky over-the-counter market (see my blogs "Can Wall Street's Clean Up Plan Work?" and "How Congress Can Fix the Crisis").

The idea is to bring some transparency to this market with a centralized clearing mechanism, as the deals are currently conducted between traders over the counter.

I have been reporting the CDS story with sources on Wall Street and government sources since last weekend.

Investors can't ignore the severity of this issue. This massive unwinding of these derivatives is happening now and stands behind the market's plunge yesterday and the VIX volatility index hitting levels not seen in two decades.

Why Now

When the Federal Reserve decided to let one of its primary dealers, namely Lehman Bros. (breaking counterparty contracts), go bankrupt, when Fannie and Freddie were taken into conservatorship (breaking counterparty contracts), when AIG was effectively nationalized (breaking counterparty contracts), when WaMu went under, these collapses triggered a sequence of credit default swap events now being unwound.

A credit default swap (CDS) is an insurance contract bought on a derivative to protect payouts in the event a company defaults on its debt. A buyer makes a series of insurance payments to a seller, and in exchange receives the contractual right to being made whole on the derivative if a credit instrument defaults or if a company goes bankrupt or restructures.

So, CDSs are essentially a form of insurance against bad debts.

An estimated $54 tn to $64 tn in CDSs now perambulate the globe, largely unregulated ever since Congress enacted the US Commodity Futures Modernization Act of 2000, which barred regulation of these trades.

TO RECAP: A key driver behind the market plunge has been the tremendous demand for cash from counterparties related to the CDS (credit default swap) payouts on these recent major credit events.

It's all happening now.

The CDS Auction Schedule

This past Monday: An estimated $200 bn to more than $1 tn in CDS written on Fannie and Freddie's debt, the two companies' senior and subordinated debt, were auctioned on Monday.

Reports indicate that protection sellers on the mortgage giants' subordinated debt won big time here, with contracts on Fannie Mae's subordinated debt recovering 99.9% of the sum insured, and swaps on Freddie Mac's subordinated debt recovering 98%, reports auction administrators Creditex and Markit.

However, CDSs on the senior debt got less, with Fannie Mae's senior swaps recovering 91.5% the sum insured and Freddie Mac's senior swaps recovering 94%. CDS sellers' losses less than expected being felt here, because  Fannie and Freddie debt have rallied since the two were placed under conservatorship;

This Friday, October 10th: When the Lehman deals get unwound. Potentially $400 bn in payouts. Lehman debt now trading between 15 cents and 19 cents on the dollar, with imputed losses of 81 cents and 85 cents on the dollar;

Oct. 23d: WaMu trades get unwound.

The last two auctions are on a tentative basis, they may be rescheduled. No information yet on AIG CDS auctions.

What Happens at CDS Auctions

At these settlement auctions, defaulted bonds can be exchanged for the par value of the bond, or in cash, or the CDS insurance seller pays buyers of this protection the difference between the bonds' face value and the market value of the bonds.

Also, traders begin to set the reference price for the underlying bonds to determine payout levels. Meaning, mortgage-backed and related bonds are being priced now, sending yet another ripple effect through financials' balance sheets as their holdings get reset-with potentially more writedowns.

Murky Trades

A big problem is the fact that CDSs are largely traded over the counter, which means it is hard to figure out who sits on the other side of the trade, not to mention the difficulty figuring out the health of their balance sheets.

All of this uncertainty is feeding the level of mistrust that has led to a creeping shutdown in the money markets and commercial paper markets.

Behind the Federal Reserve's Recent Actions

It's behind the reason why the Federal Reserve and the Treasury are working on a plan to buy huge amounts of commercial paper in the hope of unclogging the credit pipeline.

That would bring the Fed the closest it has ever been to directly lending not only to banks, but to other companies.

The Fed yesterday pledged to "take additional measures as necessary" to fight the credit crisis.

Also, on Monday the Fed said it will provide up to $900 bn in cash loans to banks facing trouble obtaining cash to try and unclog the credit markets.

Freeze in Interbank Lending

This unwinding is also the reason why interbank lending has ground to a halt, and why LIBOR rates have risen, as banks are charging each other more in the way of lending rates because they don't trust each others' balance sheets.

Another problem: Companies may have protected themselves from one or two bankruptcies in the system but not failures on the level we've seen. As one of the best credit derivatives journalists out there, Felix Salmon of Portfolio.com, notes, if they bought a CDS from Lehman to protect them on AIG, they're not protected.

So, with multiple bellyflops no one can hedge their risks perfectly.